Possibly the Perfect Place for Emergency Savings

treasure boxIf you have established a habit of saving and have built up a decent amount of cash, you may start to wonder if there is a way to hold your savings somewhere that won’t leave you exposed to inflation.  There are those who advise you to invest that money, but that’s not really a good idea.  This is the money you intend to use when the unexpected happens.  This means that it can’t be locked up in an investment.  It has to be accessible immediately.  Wouldn’t it be nice if there was an investment that would allow your emergency savings to grow with inflation, but still allow you access that money during an emergency?  It takes a little planning and patience, but there is a way.

Beneficial Features of I Bonds

If you are a “United States person,” you can put your emergency savings in I Bonds.  United States Series I Savings Bonds have some unique features that make them especially attractive for this purpose:

  • I Bond interest is linked to inflation
  • They can be purchased online
  • They can be purchased in small or larger amounts
  • They can be sold anytime after a one year period
  • They keep earning interest for up to 30 years
  • Interest is state-tax free
  • Interest is federal tax deferred

This means that if you start moving a small portion of your emergency savings into I Bonds each year, you could eventually have it all moved over.  Once your entire reserve is in I Bonds, and a year has passed since the final purchase, you can take that money out if you ever have an emergency.  If you don’t it will earn interested at whatever rate necessary to keep up with inflation.

How to Do It

Here’s a scenario that you might adapt to your own situation.  Let’s say that you have a $3000 emergency fund sitting in a money market account at the bank.

First of all, you need to open your account with the United States Treasury.  I have step-by-step instructions on how to do that here.

Then, I would suggest that you save an extra $300.  You would now have $3,300 in emergency savings.  That’s $300 too much.  Take that extra $300 and buy an I Bond.

After a year passes, that bond will be available as emergency savings only it is now probably worth more than $300 because of the inflation adjustments.  Now you are $300 too high in your emergency savings fund again.  This time take $300 out of your money market account and buy an I bond.  Wait for another year.  Now you have over $600 in I bonds and $2,700 in your money market account.  Keep moving $300 each year until all of your emergency savings is in I Bonds.

The Tax Advantages

One of the great things about doing this is that, unlike a money market account, you are not taxed at the local level, and all of your federal taxes are deferred.  You only pay taxes on a savings bond when you cash it out.  This is especially attractive when you find yourself in an emergency.

If your emergency happens to be the loss of a job and you are forced to cash some I Bonds, you will probably be doing it at a lower tax rate.   This may also true if you end up needing it while you are retired.  It’s actually better from a tax point-of-view to take money out of I Bonds when you have less income.

Important Details

If you have a lot of emergency savings, make sure that you don’t attempt to buy more I bonds than you are allowed to buy.  Each person with a Social Security Number is allowed to buy up to $10,000 in I Bonds per year.  If there are two of you, you can both buy $10,000 as long as you both have an account set up.  You can learn more about these bonds in my article: I Just Want to Save My Money.

Another thing to understand, is that if you are forced to sell an I Bond between the second and fifth year after your purchase, you will lose two months of interest when you sell it.  Since you were already losing this money in your money market account, it’s not a big price to pay for protection.  You still get all of your original principal back. After 5 years, all of the interest is yours, no matter when you cash out.

The Next Step

Since you have already proven that you have the discipline to save, you might as well take the next step and start the process of inflation protecting your emergency savings.

Inflation Protection and Taxes

Tax PaperIt’s important to understand that inflation protection is removed when taxes are applied.  Current tax rules disregard inflation, and as a result it’s easy to demonstrate that inflation can cause all of our interest on a TIPS and some of our principle to be lost through taxation alone.

When we consider our inflation adjusted returns, we can easily see that the real tax rate climbs to astronomical levels.  This simple example shows how easy it is for taxes to use up all of our real returns.

A Revealing Example

Let’s consider the effects of taxes on our inflation adjusted gains.  These adjusted gains are what finance professionals call our “real” gains.

Let’s use the actual TIPS that is being offered as I write this and our current inflation rate.  Our current inflation rate is actually 2.2% but we will use 2% make it easier and more conservative.  If you buy a $1000, Ten year TIPS with a 0.5% interest rate and experience inflation that averages about 2% during that time, the overall real gain would be 5% over 10 years and the overall inflation adjustment if it stayed the same during that period would be 20%.

After 10 years, your principle would be adjusted to $1,200 and you would have been paid about $60 in interest.  The problem is that you are not taxed on the just the $60.  The tax rules require that you be taxed on the $60 real gain + the $200 of principle adjustment.  If you are paying taxes at a low 15% rate, the rules say that you must pay 15% of $260 or $39.  Since you really only earned $60 in real value, you will have paid 65% in taxes.

That’s a very high tax rate for sure, but look what would happen if we had an unusual amount of inflation.  This is something we need to consider because our intention is to protect ourselves from both average and unusual changes in inflation.

Let’s change the average inflation to 5%.  After 10 years, your adjusted principle would now be $1500 and your 0.5% interest would be $75.  Your tax on $575 at 15% would now be $86.25.  Since you only really earned $75, taxes will have taken all of your real gain and forced you to take a loss of $11.25 on top of that.  That comes out to be a real interest rate of -0.1125% and a real tax rate of 115%.

In a taxable account, the greater the inflation, the less the protection.  I can’t honestly say that it provides any protection at all because a taxable account amplifies inflation.  It is wrong to assume that our savings is inflation protected just because we hold a TIPS.

One Safe Place

If you open a tax advantaged account such as a 401k or an IRA at a brokerage that allows you to hold TIPS within it, your savings is guaranteed to be protected.  That’s because all growth in a tax advantaged account is either not taxable or tax deferred.  This means that all inflation adjustments to your TIPS principle will only be taxed once, either before you put it into a Roth IRA or 401k or after you take it out of a traditional IRA or 401k.

The combination of a tax advantaged account and TIPS is currently the only option that I am aware of that will guarantee inflation protection to a person attempting to save money in United States.

I Bonds are Only Guaranteed in Certain Cases

I Bonds are tax advantaged in that they are exempt from state and local taxes.  That makes them an even better option than other “safe” investments.  This still does not protect them from a total loss of real gains through federal taxation on inflationary gains.  There is one more advantage though.  If an I Bond is used for tuition, it is tax free and becomes a great way to save for a child’s education.

It is also possible to sell your I bonds at a time in which your taxable income is below your exemption allowance.  If your total income falls below the your permitted exemption, then your I Bonds are tax free for that year.

A Problem for All Investments

It’s very important for all investors to understand that this problem exists outside of TIPS and I Bonds.  As far as I know, all investments have the potential of losing all of their real gains through taxes that are amplified by inflation.  Here’s an explanation of the effects on capital gains:

It’s not just a problem for investors, though.   Inflationary gains are taxed in your very own bank account.  Your interest may be only $1 per year, and you may have actually lost $5 of purchasing power in your account.  You would think that would mean that you lost $4 in purchasing power.  Since you pay taxes on your inflationary gain of $1, it pushes the loss even lower than $4.  Inflation amplifies your taxation because the more inflation there is, the more tax you pay.

Important Things to Remember about Tax Advantaged Accounts

If you have the ability to have 401k, I highly suggest that you do that.  IRAs only allow you to contribute $6,000 per year for those under the age of 50 and $7,000 per year for those over 50.  401k’s allow you to hold far more depending on your income.

If you are a high-income individual.  You currently have no guaranteed protection from inflation for savings that I know of.  It may be a good idea to consider moving your investments overseas.  There are several nations that don’t have capital gains taxes including Mexico and New Zealand.

How to Buy an I Bond

Picture of the front page of the Treasury Direct website

If you looking to buy an I Bond, but you’re not sure where you need to go or what you need to do, you’ve come to the right place.  Just follow these simple step-by-step instructions.  They will help you set up your TreasuryDirect.gov account and buy your first I Bond.  If you have a printer, you may want to print these instructions so that you don’t have to go back and forth between these instructions and TreasuryDirect.

This could take 15 – 30 minutes.  It’s good to take your time.  There’s no reason to hurry.  I suggest doing this on a computer, not a cell phone because you may be asked to allow your computer to use “Flash.” One of the demos provided at TresuryDirect uses Flash and should work fine on IE, Edge, Firefox and Chrome  browsers.

If you are wondering why you would want to buy an I bond, please read the articles: “I Just Want to Save My Money!” and “Why Bonds are Smart for Savings“.

Step 1: Gather Your Info

You need to be a “U. S. Person” and have a Social Security Number in order to buy U. S. savings bonds.  It’s one of the special privileges you have just for being a United States citizen.

You will need an address in the United States if you want to participate in buying I Bonds directly from the government, so have that ready too.

You will need to have a checking or savings account so that you have a way to pay for your I Bond.  You can’t pay with a credit card but it’s ok if you don’t have paper checks.  You just need to call your credit union or bank and get your checking account’s routing number and account number so you can pay Treasury Direct with electronic checks.

Like most online services these days, you will need to provide Treasury Direct with a valid email address.  They intend to contact you electronically with information about your account.

You have to have a computer with a browser that can create a private line to Treasury Direct.  Pretty much all computers for the last ten years have been able to do this.  The computer you are using to read this should work as long as it is a private one.  It’s probably not a good idea to do your finances on a public computer.

Step 2: Take the Guided Tour at TreasuryDirect.gov
Picture of the TreasuryDirect Guided Tour page

Although this government site has its own oddities, they’ve done a great job of holding your hand through the process of setting up your account.  You and anyone in your household that has a Social Security Number is entitled to have a free account directly with the United States Treasury.  They have a pretty nice “Guided Tour” that shows you the steps that you will go through when you set up your account.  Here it is:

TreasuryDirect.gov’s Guided Tour

If you need to type the address in, here it is:

https://www.treasurydirect.gov/indiv/TDTour/default.htm

Step 3: Complete the Application Process at TreasuryDirect.gov

The application process will allow you to set up your TreasuryDirect.gov account by entering the information that you have collected.

From the Guided Tour page, you can find the application link in the upper-right corner of the page.  It’s called “OPEN YOUR ACCOUNT NOW“.  At the time that I write this, the letters are pretty small but they are all orange.

f you are on the Treasury Direct starting page, you will find the place to open the account underneath the orange login button.  Just click on the words: “Open an Account

Make sure that you record:

  1. Your new account number
  2. Your new password
  3. The answers to your security questions (they will ask them sometimes and it will lock you out if you don’t answer them correctly)

It’s a good idea not to save these things on any computer or cell phone.  You might consider writing these down and saving them with other vital records and information you keep.   Physically locking the information in a safe would be one good idea.

Step 4: Watch the Accessing Your TreasuryDirect Account Demo
Accessing Your TreasuryDirect Account Demo Page

The TreasuryDirect site has quite a few security features.  It’s a good thing but it also makes it a bit harder to use.  I highly suggest that you watch the Flash Demo that they have created at the TreasuryDirect.gov site.  You can click on the graphic on the right or  click here.  Make sure that you say “yes” if your browser asks if you want to us “Flash”.

Here’s the address if you need to type it in:

https://www.treasurydirect.gov/indiv/myaccount/myaccount_demo.htm

Step 5: Sign In to TreasuryDirect

To log in, locate the “Account Login” section in the upper right corner of the TreasuryDirect.gov website.

Select the “TreasuryDirect” link in that section. On the next page, select the orange “LOGIN” button.

If this is the first time that you have logged in, you may be asked to check your email for a special passcode.  This is a security protection to make sure that it is really you.  You must enter that code that you get from your email.  You can choose the option to allow TresuryDirect to remember your browser.  That way you won’t have to get special codes in your email every time you attempt to log in.

On the next screen you must enter your new Account Number.  That’s not the passcode.  That’s the one that you used when you first applied in step two above.  After typing in your account number, hit the “submit” button.

You will then be taken to a screen that allows you to choose an image and a phrase.   This might seem a bit silly, but it is actually a good security method.  TreasuryDirect will show you this picture and phrase every time you log in.  It’s a way for you to know you are actually accessing TreasuryDirect and not a fake.

If that image is ever not the one you remember. It’s a good idea to close your browser and contact TreasuryDirect by phone and tell them that something is wrong before going on.  All these things are there to make sure that you are protected and that’s a good thing.

Below that you will see a graphical keyboard.  Instead of typing your password using your keyboard, you need to type your password using the graphical keyboard, with your mouse.

After you hit the “submit” button, the weirdness is pretty much over.  You will now be signed into TreasuryDirect.  You should see a welcome message with your name at the top of the screen.

One other strange thing to keep in mind about the TreasuryDirect website: Don’t try to use your “back” button in the browser.  That will force you out, requiring you to log in.  TreasuryDirect will only allow you to use the buttons on the page to navigate.  All these things help the web site give you a very secure environment.

I did find some graphical instructions at WikiHow that may also be very helpful.

Step 6: Buy Your I Bond

Now for the fun part.  We are finally to the point at which you can buy your first I Bond.

Now that you have logged into your account, you will need to click on the button at the top called: Buy Direct

You will then see a list of options of things you can buy.  In the list you will see an option for “Series I – An accrual-type security with a combination interest rate of a fixed and an inflation rate”

Select that option and Hit the blue Submit button.

You will a place to enter your “Purchase Amount“.  Enter the bond amount here.  You can have a bond as low as $25 and if this is the only bond you plan on buying this year, you should be able to have one for as high as $10,000.  I haven’t tried that before but it should work as long as you have the money.  Make sure that the “Select a source of funds” drop-down box shows your checking account and then hit the “Submit” button.

That’s it.  When you log back into TreasuryDirect, you will be able to check up on your I Bond and see its current value.  This is also the place to go when you are ready to sell your bond.  You can’t do that for the first year, because that’s one of the rules.  It’s best to hold on to your bond for five years so that you get all the interest.

You can also buy other kinds of treasury investments this way including TIPS.  That’s all it takes to take advantage of one of the safest and most effective ways to save for your future.

Why Bonds are Smart for Savings

Colorful Eggs in Small Colorful BucketsBonds are one of the easiest and most common ways to save money for the long term.  There’s a good chance you already own one.  If you have a certificate of deposit at your bank or your credit union, you own a kind of a bond.  CD’s are quite a bit different than other kinds of bonds, but they have many things in common.

Rather than going over different kinds of bonds, I’d like to explain why  they are a good investment for those of us saving for future needs.  In a previous article, I described two ways of looking at our investments.  Bonds are very useful for the part of our savings that we intend to preserve.

Bonds Eliminate Timing Risk

I mentioned back in my introduction to TIPS that bonds are actually a  type of loan.  CD’s are loans that you make to the bank.  If you ever wondered how to turn the tables on a bank and get them to pay you interest, that’s how.  If you have had a CD before, you know that it has an end date.  That’s how bonds work.  They “mature.”  When they do, you get your money back.

Because bonds have a due date, they are great for eliminating timing risk.  Bonds come with a promise to return your money on a specific day.  If you intend to go on a big vacation in two years, you can get a two year CD at the bank and earn higher interest than you would in a regular savings or checking account.  When the CD matures, you get your money back and all the interest right when you need it.

You can imagine what might happen if you put that money in a mutual fund for two years.  If you happen to have planned your vacation during the next stock market crash, you probably would have to change your plans.  It might be ok to miss your vacation, but putting off your retirement because you took that risk would probably be a bigger deal.

Certificates of Deposit and Inflation

Taking out a two year CD might not be that bad.  At the time I write this, CD rates are still quite a bit lower than the rate of inflation.  When that is true, you end up paying the bank to hold and protect your money.  That’s not always a bad idea.  Putting all that money in your house might be worse, but it sure would be nice to be able to keep up with inflation don’t you think?

I Bonds vs. CD’s

You might consider I Bonds for a two year holding time or more.  You can’t take your money out for the first year, so if you need the money sooner than that, it wouldn’t be a good idea.  If you need the money in less than five years, it would still be a pretty good idea to put your money in an I Bond because it protects your purchasing power at the cost of losing three months of interest.  It’s still better than most bank CDs at the time that I write this.  After five years of waiting, you can take the money out any time.  If you have more than 30 years to wait, you will have to sell your bond in thirty years and get a new one.  You can find out more about I Bonds in another article.

The advantage of using an I Bond over a CD is that you are more certain to keep up with inflation.  There are CD’s that allow you to “step up” your interest rate if the interest rates go up at some point.  The problem with that is that interest rates and inflation are not really linked.  The will of the government is in between.   Governments occasionally force interest rates lower as a way to “fix” the economy.  As a result, CD’s have proven to not be a very precise way to protect your money’s purchasing power.

Using a Bond Ladder

Ladder with fruitYou may have seen an article or heard someone at your bank talk about putting some money in a CD ladder.  This arrangement helps you take advantage of changes in interest rates over time.  It’s another way to attempt to deal with inflation issues as well.

The idea is that you split up your money, and buy CD’s or bonds with different maturity dates.  For instance you might buy one for six months, another for one year and another for two years.  The idea being that every six months you would have a CD coming due.  When it does, it allows you choose whether you need to use some of the money or put it back into another CD.  It also allows you to take advantage of changes in the interest rates as they go up.

When you are trying to save your money for later, bond ladders have much different purpose.  When you are using inflation protected bonds like I Bonds or TIPS you don’t really have to worry about the interest rates.  Remember that taking advantage of rising interest rates is the kind of thing we do with the part of our money set aside for opportunity investing.  When we are dealing with the preservation side, what we concern ourselves with is timing.  We just need to ask ourselves: When do I need this money?  In this case, we would use a ladder to put the right amount of money in the right place in the future to meet our needs.

Here’s an example.  Suppose you need your money in 15 years.  It may require that you take out a ten year TIPS, and after 10 years you need to remember to buy another 5 year TIPS when it matures.  You can think of your needs like buckets of money.  Let’s say that you have one bucket for each year during your retirement.  You need a ladder of bonds that reach to each bucket in order to fill them with the right amount of money so that you meet all of your needs.

Beware of Bond Mutual Funds

Bond mutual funds don’t have a maturity date.  Shorter duration funds may be safer than stock funds, but they are definitely more risky than just owning the bonds.  That’s because the fund share prices change every day based on market forces, not inflation.  I plan to explain that more in an article about mutual funds.

A Smart Way to Plan

Bonds are a great way to plan because they are based on time commitments.  Not everything in life can be planned, but for things that need to be, it really makes sense to use investments that have commitments built into them so that you can be sure to have money when you need it.

10 Articles About Inflation Protected Bonds

Tree Under Umbrella

source: freeGraphicToday (Pixabay)

Here’s a list of 10 articles I found that provide information about Inflation Protected Bonds.  Learn more about how I Bonds and TIPS work and good reasons to use them for long-term savings.

Zvi Bodie: I Bonds Are Best for Most Investors

by ThinkAdvisor.com

This is an interview with Professor Zvi Bodie about the safest way to invest for your retirement needs.  He explains the clear benefits and why he believes that more people need to hear about this ultra-safe way to prepare for retirement.

What are I Bonds?

by www.ibonds.info

This overview of I Bonds briefly explains their benefits and how they compare to other investments in general.  It describes I Bonds as a safer investment than other kinds of investments.  It has some very helpful graphics.  I believe is the best site about I Bonds I have found.  You might want to spend some time here looking around at all it has to offer.  This site also sports an up-to-date display of the current interest rate being offered by I Bonds in the upper right hand corner and contains great quotes that people have made about the benefits of I Bonds.

Fixed income that isn’t fixed

by Fidelity Viewpoints, Fidelity Investments

This article provides a good overview of TIPS from an investment perspective.  It also has a discussion about ETFs that give smaller investors access to something called Floating Rate Loans.  I’m not a fan of those at this time, but this article does have a discussion of those as well.

Hedge Your Bets With Inflation-Linked Bonds

by Christina Granville, Investopedia

This article give some great background on the history of Inflation Linked Bonds and provides a brief overview of how they relate to investments in an investment strategy.  I tend to not care about investment strategies in that I use inflation protected bonds for long-term savings.  This article also provides the names the inflation protected bonds available in other countries.  Don’t get too concerned about the discussion about deflation.   She mentions at the end, it doesn’t apply to those of us using it for long-term savings.  I intend to address that issue in another article.

The Investment TIPS You Should Care About

by Wade Pfau on Forbes

This article is directed toward those of you who already think in investing terms.  It’s a bit technical compared to some of the other articles.  The author discusses some of the oddities regarding TIPS and their relationship to other bond investments.  He briefly discusses the idea of real and nominal yield and the difference in thinking that goes along with investing in TIPS.

TIPS: Understanding Treasury Inflation-Protected Securities

by Dan Caplinger on The Motley Fool

This is a great article that covers the history that the United States had with the bond market and inflation during the 1970s and 80s.  It does a great job of explaining the benefit and protection that TIPS provide.  The article concludes by recommending ETFs and Mutual Funds.  I’m not a huge fan of funds.  I hope to explain my viewpoint in a future article, but I have held them at times because I believe that they are some of the safest ones to hold.  This article is not very technical and a great one to read to get some background on TIPS.

Negative TIPS Yields

by Thomas Kenny at The Balance

One of the most alarming and confusing things to discover about investing in TIPS is that they can show a negative yield during certain times in the economy.  This article explains why that happens.  This is another topic I hope to make more clear in the future as well.  It’s good to note that your bank account has been giving you negative yields for several years in a row when you adjust your returns for inflation.  TIPS are just more easily exposed when this happens.  You can choose to not buy TIPS when they go negative.

Tracking Inflation and I Bonds

by TIPS Watch

This is a page on a site all about TIPS that tracks the interest rates of I Bonds.  It also explains how I Bond rates are calculated.  If you want to see the history of I Bond rates, you can see that on this tracking page.

Series I Savings Bonds

by Treasury Direct

This is the United States Treasury Department’s information on I Bonds.  You can get all of the most accurate and latest information here including the current interest rates and how they are calculated.   If you want to buy them, you are only a few clicks away.

Treasury Inflation-Protected Securities (TIPS)

by Treasury Direct

Here is the United States Treasury Departments description of TIPS.  This is where you will find the most up-to-date information on them.  It’s not that hard to understand but you may need to invest a little time reading and thinking about it.  I don’t think you need to know much about investing to understand what it said here.  You can also buy TIPS directly from this site.

 

Bonus Articles

How to Buy an I Bond
If you are ready to buy an I Bond but don’t know how to get around at TreasuryDirect.gov, I can help you with that here.

Stressed about Savings? Divide and Conquer
You might consider a strategy that separates savings from your more risky endeavors. Here’s how I like to think about it.

Inflation Protection and Taxes
Taxes are a real problem when it comes to inflation protecting your savings. Learn more about that here.

I Just Want to Save My Money!

So, you are at the point where you have decided to stay out of the market and all you really want to do is save what you have for later.  The problem is, you haven’t found a way to save money for longer than a year or so, without feeling the effects of inflation.  A simple look at the inflation rates reveal that you would have to get an interest rate of somewhere around 2% just to break even!  With 5 year CD rates at 1.5%, you realize that you would be paying the bank half a percent to keep your money from you!  If you were an irresponsible spender, that might make sense, but you are serious about saving.  Now, am I the only one who thinks this is crazy?  Why are more people not upset about this?

Running Toward Risk

One reason might be that people have been placated by the possibility that they could make money using the stock market.  It’s hard for me to believe that this was not the intent of denying us the right to save our money.  I believe it is dishonest for any government to act like money is money if it can’t be saved for more than a few months.  It would also be pretty hypocritical for a government to complain about the number of people without savings, if they haven’t even provided a way to save this so-called money.  Well, I’m happy to inform you that they actually have provided a way to save.  There must be a few godly people in the government because they gave us a way to save money that can actually avoid much of the exposure to inflation.  In the United States, there are actually two ways.  They aren’t perfect, but they do appear to be a step in a good direction.  This information is so little known, and so important, that I really wanted to share it.

The Old Way

I’m going to assume that you are familiar with how a savings account accrues interest.  It’s important that you also understand how CDs or Certificates of Deposit work at the bank too.  A typical CD is a special account in which you give the bank your money for a dedicated amount of time with the promise from them to pay you interest.  If you take your money out early, there is a penalty.  The interest is calculated on the amount of money you initially put into the account, plus any interest accrued.  Now if that interest rate is less than the rate of inflation, you are actually losing money.  That’s because what you can actually buy with the money has become less over time, while at the same time, the interest didn’t increase fast enough to give you the same purchasing power your money had when you earned it.  So what did the United States Government do to help us in this situation?

The New Way

In 1997 the United States Treasury provided a new way of saving by issuing something called: “I Bonds. ” In order to understand what those are, you kind of need to understand what a normal “bond” is.  Stocks and bonds are really different even though they are often spoken of together.  When you “buy” a bond, you are actually loaning your money to someone.  Pretty confusing right?  It sounds like you are purchasing something when, in reality, you are loaning someone else your money!  Well, no matter what it seems like, that’s what it is.  When you buy a bond, you become the bank.  You can loan money to companies by buying corporate bonds.  You can also loan money to a government by buying government bonds.  That’s one way that United States Treasury finances their needs and they allow individuals or institutions to buy bonds.  One institution that does this is, … surprise…. your bank.  In fact, those CDs you get are often backed by government bonds.  I tell you this to help you understand that that these I Bonds are not really a new risk to you.  You are accessing the same United States Treasury only in a different way.  Let’s look at how a typical bond earns money for you.

100 Dollar Series I Savings Bond Image With Picture of Dr. Martin Luther King
source: TreasuryDirect.gov

A good old-fashioned bond used to be printed on paper, kind of like a dollar bill.  On the face of this bill, it had a value, like $100.  If you were to buy this bond at its face value you would loan the government $100 and they would give you this bill.   In those days, part of your loan agreement was that every six months or so, the government would pay you by sending you a coupon in the mail for all the interest they owed you on that money so far.  You could then go cash the coupon and use the money.  That was your interest for allowing the government to use your $100.    Another thing about your bill is that it would have a term associated with it that was recorded in a book somewhere.  That’s the amount of time you agreed to allow the government to use your $100.  When time is up, you can cash in your bill to get your $100 back.  As long as they are using your $100, they promise to keep sending you your interest as coupons in the mail.  Well, it’s pretty obvious that computers were bound to change this process a bit.

Buying Treasury Bonds Today

Now days, we use the same terms, but the paper is almost gone.  You still can buy a bond, but the coupon never gets sent to you, it just accumulates in an account.  In fact, the Treasury is willing to compound the interest now just like a CD.  Not only that, you can go to the Treasury’s web site and open an account online, just like using online banking.  Anyone with a Social Security Number is eligible.  Their website even has a clever name:

TreasuryDirect.gov

Yes, you have your very own online bank account waiting for you, but wait, there’s more.  Let’s go back to talking about I Bonds.  I Bonds, or more accurately Series I Savings Bonds, are what the Treasury calls “Inflation Adjusted Bonds”.  That’s right.  They’re bonds whose interest is tied to inflation.  That means that when inflation goes up, the interest rate on these bonds go up too.  Part of the interest calculation is connected to an index that follows the cost of goods in the United States called the CPI-U.  The CPI-U is a good topic for another article.  It’s good to know, for now, that your interest rate will go up when inflation goes up.  It’s also important to understand that what goes up, must also come down.  If inflation goes down (yes that would be deflation) the rate goes down, but the Treasury decided that they would not allow your bonds to ever go below your original amount.  That means you could actually make money in a deflationary time as well.  If you want to buy an I Bond, I have step-by-step instructions available at this website.

The Tax Problem

Now let’s say that you are convinced and you’re ready to put some of your savings into one of these I Bonds.  First, let’s talk about the down side.  I Bonds, unfortunately, are not protected from taxation by the IRS.  The United States Tax Code, for some reason, doesn’t recognize the fact that you already earned this money once.  Evidently, our congress believed that simply recovering your money’s lost value to inflation is a taxable event and that we owe money for that.  This means that you aren’t completely protected from inflation.  You will have to treat your interest on an I Bond as “income” and report it.  That’s the bad news.  This same bad news spans all investments including your bank account.  That’s not much comfort, but there are two tax advantages that you also need to consider as well.

First, we are allowed to defer reporting our interest to the IRS.  You can choose to not report your interest until you need to use the money.  The reason that this is significant is that you can wait to use the money for a rainy day, such as, a year when you don’t have much income.  For many of us, that will probably be during retirement.  At that time, you may not even be taxed, depending on what other income you have.  The other advantage is that these bonds are not taxable by state or local governments, like your bank account is.  So, even though taxes make things less than perfect when trying to shelter yourself from inflation, these I Bonds are one of the best things we have.

If you are interested in learning more about the effects of taxes on our inflation-protected savings, make sure to check out my post: Inflation Protection and Taxes.

Some Important Details

Now for some important details about I Bonds:  You can buy an I Bond for $25 or more at Treasury Direct, but you can’t buy more than $10,000 in any given year.  For many of us, that’s not an issue, but there are some who would like to save more than that.  Well, there is another trick… You can use your tax return to buy about $5000 more and guess what, you will get the paper certificates!  They are pretty cool, I have to admit.  There are more pictures of them at Treasury Direct.

Also, I Bonds are a long-term investment.  They act kind of like a CD in that there are restrictions about when you can take the money out.  You can’t cash them in for the first full year.  Also, you are penalized if you cash out before a 5 year term, but the penalty is not very bad.  You would have to give up the previous three months of interest, but that’s it.  Since you probably want to save anyway so that’s not a big deal.  The good thing is that you can keep your money in this bond for 30 years!  Yes you read that right.  Anywhere from 5 to 30 years, the government is willing to keep growing your interest rate with inflation and allow you cash out any time.  After 30 years the interest stops so it’s a good idea to cash it in and get a new one so you keep earning interest.

If you are looking to shelter more than that, or were wondering how you could do something like this in a retirement account, there is another option.  Check out my post:  Introducing Treasury Inflation Protected Securities (TIPS).  Thankfully, you can save money after all!